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January 26, 2015 12:00 AM

ESG strategies largely absent from ETF landscape

Ari I. Weinberg
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    As the integration of passive strategies into institutional portfolios accelerates, another unequivocal trend — the consideration of environmental, social and governance factors in investment decisions — remains primarily a pivot point for more socially aware, active investment decisions.

    Consider the second principle of the United Nations Principles for Responsible Investment, which now has more than 1,300 signatories around the world: “We will be active owners and incorporate ESG issues into our ownership policies and practices.”

    This tenet plays nicely into public (and private) agitation by asset owners, as well as the case for divestment or exclusion from portfolios. According to The Forum for Sustainable and Responsible Investment, investors or money managers responsible for nearly $6.2 trillion in U.S.-domiciled assets incorporated ESG factors into their investment decisions last year.

    But how much of that is indexed or benchmarked exclusively to ESG factors or ratings is difficult to determine. Perhaps, exchange-traded products eventually will serve as a proving ground for the greater viability of ESG indexing more broadly.

    Yet, among U.S.-listed exchange-traded products, 10 “socially responsible” products account for only $1.14 billion, or just 0.06%. of ETP assets, according to research firm XTF Inc. And nearly 20% of that figure arrived through November and December launches of twin products from State Street Global Advisors and BlackRock.

    With seed funding for both provided by the $53 billion United Nations Joint Staff Pension Fund, the SPDR MSCI ACWI Low Carbon Target Index and iShares MSCI ACWI Low Carbon Target Index have drawn very limited trading interest despite holding $225 million in assets and a 20-basis-point expense ratio.

    “Some investors may consider the variety of ESG definitions and implementation techniques challenging, since this could result in a lack of standardization,” said Carol Boykin, representative of the Secretary-General for the United Nations Joint Staff Pension Fund. “We view ESG investing as more of an opportunity than a challenge.”

    Outside of ETPs, Sweden's AP4 pension fund and France's Fonds de Reserve pour les Retraites have earmarked $1.5 billion for funds based on MSCI's low-carbon indexes since their September launch, according to MSCI. The $963 million University System of Maryland Foundation also invested in the iShares low-carbon ETF at launch.

    The opportunity surrounding ESG factors is not lost on the largest institutional managers. BlackRock managed $257 billion in “social investing products” as of June 2014, and State Street managed $217 billion on ESG factors as of September 2014, according to each company.

    “Despite the undeniable proliferation of ESG factor indexes, these benchmarks have not yet made their way to investment committees, consultants, and risk models,” said Chris McKnett, SSgA's head of ESG investing in Boston. “The most tried and true method is to alter the universe of a broad-market benchmark to exclude certain securities and optimize in an attempt to build a return stream and risk profile that closely matches that index,” he said.

    But that method effectively ignores ESG factors as risk premiums, according to a working paper from New Amsterdam Partners LLC in New York. Using Thomson Reuters Corporate Responsibility Data on 680 mostly large-cap U.S.-listed companies, Michelle Clayman, chief investment officer, and Indrani De, director of quantitative research, at New Amsterdam Partners, found that randomly generated portfolios of the highest rated stocks by ESG score “tended to improve the return and risk-adjusted return distribution.” Specifically, they found a strong negative correlation between ESG ratings and stock volatility, which got stronger in more volatile markets after the financial crisis.

    “These are factors that measure corporate citizenship,” said Herb Blank, head of ESG solutions for S-Network Global Indexes in New York. “Safety standards, community issues, violating intellectual property rules — these are all factors that can open any company up to real, tangible liability.”

    Now, as large institutions like Harvard Management Co., which manages assets of the $36.4 billion endowment of Harvard University, and $292.9 billion California Public Employees' Retirement System actively and openly espouse ESG factors for investment decisions across their portfolios, benchmarking and indexing to include ESG could be soon to follow.

    For example, the $178.3 billion New York State Common Retirement Fund, Albany, held nearly $250 million in passive strategies indexed to the FTSE Environmental Technology 50 index and the HSBC Climate Change ex-Nuclear index, for the fiscal year ended March 31, 2014.

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